C18 CORPORATE BONDS

BASIC #

The term “bond” refers to a variety of assets which offer a wide range of interest rate payments from fixed cash payments, to accruals without cash, to payments in the form of additional securities.

BOND INDENTURE & ROLE OF CORPORATE TRUSTEE #

The bond indenture is a document that sets forth the obligation of the issuer & the rights of the bond holders.

Corporate trustee act in a fiduciary capacity on behalf of the bondholders. They authenticate the issue & monitor the corporate activities to make sure the issuer abides by the indenture’s covenants.

All corporate bonds offering over $5 million & sold in interstate commerce must have a corporate trustee as set forth in the Trust Indenture Act.

MATURITY DATE #

The maturity date of a bond is when the bond issuer’s obligations are fulfilled. At maturity, the issuer pays the principal & any accrued interest or premium. The contract may terminate prior to the maturity date if the corporation chooses to retire the bonds early.

INTEREST PAYMENT CLASSIFICATIONS #

1. Straight– coupon bond/ fixed rate bonds : They have a fixed interest rate set for the entire life of the issue.

* Participating bonds : Pays atleat the specified interest rate but may pay more if companies profit increase.

* Income bonds : Pays almost the specified interest but they may pay less if the companies income is not sufficient.

2. Floating rate bonds/ variable rate bonds : The interest paid is generally linked to some widely used reference rate such as LIBOR or the Federal Fund Rates.
3. Zero coupon Bonds: There is not a cash interest payment. Instead the bondholder earns a return by purchasing the bond at a discount to Face value & receiving the full face value at maturity. Variations of the zero-coupon bonds include:

* Deferred interest bonds (DIB) : DIB will not pay  cash interest for some number of years early in the life of the bond. That period is the deferred-interest period.

* Payment in kind bonds (PIK) :  PIK bonds pay interest with additional bonds for the initial period, and then cash interest after that period ends.

* A zero-coupon bond’s interest rate is determined by the original-issue discount (OID):

original-issue discount (OID) = face value — offering price

There is a zero reinvestment risk in zero-coupon bonds.

BOND TYPES #

1. Mortgage Bonds : Those who own mortgage bonds have a first-mortgage lien on the properties of the issuer. This security allows the issuer to pay a lower rate of return than it would have to pay on unsecured bonds.
2. Collateral trust Bonds : Collateral trust bonds are backed by stocks, notes, bonds, or other similar obligations that the company owns. The underlying assets are called the collateral.
3. Equipment trust certificates (ETCs) :ETCs are a variation of a mortgage bond where a particular piece of equipment underlies the bond. The usual arrangement is that the trustee purchases the equipment and leases it to the user of the equipment  who pays rent on the equipment, and that rent is passed through to the holders of the ETCs. The payments to the creditors are called dividends.
4. Debentures : debentures are unsecured bonds.  Most corporate bonds are debentures and usually pay a higher interest rate for that reason.
5. Subordinated debenture bonds : They have a claim that is at the bottom of the list of creditors if the issuer goes into default. They are bonds that are unsecured and have another unsecured bond with a higher claim above them.
6. Convertible debentures: They give the bondholder the right to convert the bond into common stock. This feature will lower the interest rate paid.
7. Exchangeable debentures : These are convertible into the common stock of a corporation other than that of the issuer.
8. Guaranteed bonds : Bonds issued by one company may also be guaranteed by other companies. These bonds are known as guaranteed bonds.

INTEREST PAYMENT CLASSIFICATIONS #

1. Call & refunding provisions : Call and refunding provisions are essentially call options on the bonds that the issuer owns and give the issuer the right to purchase at a fixed price either in whole or in part prior to maturity. A call provision can either be a fixed-price call or a make-whole call.

* Fixed-price call : The firm can call back the bonds at specific prices that can vary over the life of the bonds as specified in the indenture.

* Make-whole call : In this case, market rates determine the call price, which is the present value of the bond’s remaining cash flows subject to a floor price equal to par value

2. Sinking Fund Provision : A sinking fund provision generally means the issuing firm retires a specified portion of the debt each year as outlined in the indenture. The bonds can either be retired by use of a lottery where the owners of the selected bonds must redeem them, or the bonds are purchased in the open market. Unlike the call provision, there may be advantages to the bondholders. First, the retirement of bonds improves the financial health of the firm. Second, the redemption price may exceed the market price.

3. Maintenance & Replacement Fund (M&R) : M&R has the same goal as a sinking fund provision, which is to maintain the credibility of the property backing the bonds. M&R provision is more complex since it requires valuation formulas for the underlying assets.
4. Tender offers : Tender offers are usually a means for retiring debt for most firms. The firm openly indicates an interest in buying back a certain dollar amount of bonds or, more often, all of the bonds at a set price. The goal is to eliminate restrictive covenants or to use excess cash.

CREDIT RISK #

                                                                          CREDIT RISK

                                        Credit Default Risk                        Credit Spread Risk

A method commonly used to evaluate credit spread risk is spread duration. The duration of the spread is the approximate percentage change in a bond’s price for a 100 basis point change in the credit spread assuming that the Treasury rate is constant.

EVENT RISK #

Event risk addresses the adverse consequences from possible events such as mergers, recapitalizations etc.  Such events can drastically change the firm’s capital structure and reduce the creditworthiness of the bonds and their value. Investors can lobby for clauses in the indenture to activate a put option for a variety of reasons including a change in the bond’s rating.

HIGH YIELD BONDS #

High-yield bonds are those bonds rated below investment grade by ratings agencies. There are many types of high-yield bonds.

1. Companies issuing bonds with a non-investment grade rating: Such issuers include young and growing companies that do not have strong financial statements but who have promising prospects.
2. Fallen angels : They are bonds that were issued with an investment-grade rating, but then events led to the ratings agencies lowering the rating to below investment grade.
3. Restructuring & Leveraged Buyouts : Restructurings and leveraged buyouts may increase the credit risk of a company to the point where the bonds become non-investment grade.

High-yield bonds can have several types of coupon structures. There are reset bonds, where designated investment banks periodically reset the coupon to reflect market rates and the creditworthiness of the issuer. There are also deferred-coupon structures, which include three types:

1. Deferred-interest bonds : sell at a deep discount and do not pay interest in the early years of the issue, say, for three to seven years.
2. Step-up bonds : pay a low coupon in the early years and then a higher coupon in later years.
3. Payment-in-kind bonds : allow the issuer to pay interest in the form of additional bonds over the initial

DEFAULT RATE #

A default occurs if there are any missed or delayed disbursements of interest and/or principal.

1. Issuer’s default rate : The issuer default rate is the number of issuers that defaulted over a year divided by the total number of issuers at the beginning of the year.
2. Dollar default rate : The dollar default rate is the par value of all bonds that defaulted in a given calendar year divided by the total par value of all bonds outstanding           during the year.

RECOVERY RATE #

The recovery rate is the amount received as a proportion of the total obligation after a bond defaults.  The value of the total obligation requires computing the present value of the remaining cash flows at the time of the default.